One links their Facebook account to the bank, and an investment portfolio is generated. And for nearly no cost – seemingly preposterous. Or is it? This article will explore the shifts in views in investing, new opportunities in the market and how investing will become a common practice for the average citizen.
“Should I invest in Bitcoin or Tesla?” This a common question from a friend to anyone in the field of finance. Although the average citizen is still sceptical of the financial markets, it is very difficult to ignore the returns people are making with cryptocurrencies.
No one likes to earn 1% interest on their bank account – or even lower – and lack the flexibility to withdraw whenever they wish. On the other hand, the average citizen is either too afraid to go into investing, or does not trust the system. Hence the idea of earning a high return on their cash becomes a distant reality for many. How and why then, will that citizen place their money elsewhere?
Goals of a Portfolio Manager
Before looking into potential investors, it is perhaps wise to inspect the future of the asset management profession. Setting aside the intricate levels within the industry, a person who manages someone else’s money has one objective and one restriction: to provide the expected returns, according to the risk tolerance of the investor. Within this framework, the portfolio managers gather data, and using their knowledge, transmute data into investment returns.
The Future of Finance
Investigating and outlining a path for The Future of Professions, Richard and Daniel Susskind focus on the creation and distribution of knowledge. In a nutshell, they argue that most professions will be focused on production and distribution of practical expertise. Such evolution will ease the transition to automation with AI, where distribution channels will use the Internet to deliver personalized and cheaper solutions to customers. At the end of the day, the financial professions known for their monopoly over investment knowledge will lose ground to smarter and faster-acting systems.
Opportunity = Attention
A lucrative business model appears at this point. Entrepreneurs investing in AI could reap the rewards by targeting the masses, as processing data and providing personalized responses
become extremely cheap. IBM’s Watson can connect society to social media and track an investor’s habits, thoughts or preferences. Consequently, the common citizen can receive a personalized portfolio that is usually only available to high net worth individuals. Using this structure, AIs like Watson can invest in ETFs or even attempt to filter stocks that meet their client’s preferences.
The final picture is the combination of AI and personalized ETF/stock portfolios for the masses; those who cannot afford asset managers, and do not want the low rates at banks.
Although some argue that a good deal for the consumer is bad news for the business owner, this is a unique situation. By providing tailored marketing and sales to clients, the wealth managers can increase their retention and satisfaction rates. And adopting this methodology to serve a larger audience, they can maintain their margins while boosting their inflows. The sacrifice in earnings for growth prospects may not be as harsh as it is in standard business models. Since the attention the required by the masses is handled by AI, wealth managers can focus on their investment strategies.
The Counter Argument
So if investing is so easy, who needs intermediaries? Why would anyone want to pay a fund manager when one could build its own portfolio of ETFs or stocks? At this point, it is sensible to bring up the Apple vs. Android argument. Many techies would argue how an Android phone is superior in technical specifications and in its flexibility in customization. Yet, even under such scrutiny, many go ahead and buy an iPhone. How so? Because the numbers are not the only factors that one takes into account when making a decision.
The seamless purchase, easy access to support and beauty are all qualitative perspectives that prompt people to buy an iPhone. And on top of that, people do not want to overthink. They need a tool for an application and something that solves that conveniently takes their attention.
A similar scene is evident in the field of investment. People do not want to think or stress themselves about building an ETF portfolio. So when there are services providing that exact solution, and at a cheap cost that comes from mass adoption, people will flock into investing more in the capital markets. When or how fast this happens is yet to be seen. One thing, however, is certain: the
average citizen is curious, and this curiosity is building peoples’ desire to invest.
Cryptos Rally Slightly
Following one of the worst crypto crashes since 2015, cryptocurrencies posted moderate recoveries.
Editor’s Remarks: Bitcoin dipped into four-figure territory at the nadir of the short-lived crash that many touted as the “end of cryptocurrencies”. However, most major currencies were up yesterday as they commenced a recovery. Ripple, which fell as low as $0.90, was up to $1.40 by midday, while NEO resumed its upward trend. Bitcoin’s recovery has been notably weaker than its smaller cousins, some of whom are up 60% in the last 24 hours against bitcoin. Ethereum gained back some of the ground it lost too and is settling in once more above the $1,000 mark.
Read more on Cryptocurrencies:
The Risk of a Correction in the Equity Bull Market
Since March 2009, the US stock market has been trending higher. If it can continue to make new highs, or at least, not correct to the downside by more than 20% until August of this year, it will be the longest equity bull market in US history.
The optimists continue to extrapolate from the unexpected strength of 2017 and predict another year of asset increases, but by many metrics the market is expensive and the risks of a significant correction have become more pronounced.
Equity volatility has been consistently low for the longest period in 60 years. Technical traders are, of course, long the market, but, due to the low level of the VIX, their stop-loss orders are unusually close the current market price. A small correction may trigger a violent flight to the safety of cash.
Meanwhile in Japan, after more than two decades of underperformance, the stock market has begun to play catch-up with its developed-nation counterparts. Japanese stock valuation is not cheap, however, as the table below (which is sorted by the CAPE ratio) reveals:
Source: Star Capital
Global economic growth surprised on the upside last year. For the first time since the great financial crisis, it appears that the central bankers’ experiment in balance sheet expansion has spilt over into the real economy.
An alternative explanation is provided in this article:
A different view of the risks facing equity investors in 2018 is provided by Louis-Vincent Gave of Gavekal.
The author highlights the pros and cons of tightening monetary policy in Japan. The cons which are of interest:
- PPI is around 3%
- The banks need a steeper yield curve to survive
- The trade surplus is positive once again
- The US administration has been pressuring Japan to encourage the Yen to rise
It is doubtful that the risk of the Bank of Japan tightening the policy is very great – they made the mistake of tightening too early on previous occasions, to their detriment. In any case, raising short-term rates will more likely lead to a yield curve inversion making the bank’s position even worse. The trade surplus remains small and the Yen remains remarkably strong by long-term comparisons.
This brings us to the author’s next key risk (which, given Gavekal’s deflationist credentials, is all the more remarkable) that inflation will surprise on the upside:
Migrant workers are no longer pouring into Chinese cities. With about 60% of China’s citizens now living in urban areas, urbanisation growth was always bound to slow. Combine that with China’s ageing population and the fact that a rising share of rural residents is over 40 (and so less likely to move), and it seems clear that the deflationary pressure arising from China’s urban migration is set to abate.
Reduced excess capacity in China is real. From restrictions on coal mines to the shuttering of shipyards and steel mills, Xi Jinping’s supply-side reforms have bitten. At the very least, some 10m industrial workers have lost their jobs since Xi took office (there are roughly 12.5m manufacturing workers in the US today).
Gave recalls the Plaza and Louvre accords of 1985 and 1987, reminding people that the subsequent rise in bond yields in the summer of 1987 brought the 1980s stock market bubble to an abrupt halt.
Gave foresees inflation delivering a potential a triple punch; lower valuations for asset markets, followed by tighter monetary and fiscal policy in China, will trigger an incendiary end to the unofficial ‘Shanghai Agreement’. In 1987, it was the German government which offered the safe haven, short-dated RMB bonds may be their counterpart in the ensuing crisis.
This brings the author to the vexed question of how the Federal Reserve will respond. The consensus is that it will be business as usual after the handover from Yellen to Powell, but what if it’s not?
Gave proposes four scenarios:
- More of the same – along the lines of the current forecasts and ‘dot-plot’
- A huge US fiscal stimulus forcing more aggressive tightening
- An unexpected ‘shock’ either economic or geopolitical, leading to renewed QE
- The Fed tightens but inflation accelerates and the rest of the world’s central banks tighten more than expected
The final risk which the author assesses is the impact of rising oil prices. It has often been said that a rise in the price of oil is a tax on consumption.
The chart below shows the decline in the true money supply:
The Baker Hughes US oil rig count jumped last week from 742 to 752, but it is still below the highs of last August and far below the 1609 count of October 2014. The break-even oil price for US producers is shown in the chart below:
Source: Geopolitical Futures
If the global price of oil were entirely dependent on the marginal US producer, there would be little need to worry, but the world rig count has also been slow to respond and non-US producers are unable to bring additional rigs on-line as quickly as their US counterparts in response to price rises:
Source: Baker Hughes
An additional concern for the oil price is the lack of capital investment over recent years. Many of the recent fracking wells in the US are depleting more rapidly. This once dynamic sector may have become less capable of reacting to the recent price increase. This may not be fully convincing, but a structurally higher oil price is a risk to consider.
As Keynes famously said, ‘the markets can remain irrational longer than I can remain solvent.’ Global equity markets have commenced the year with gusto, but, after the second-longest bull market in history, it makes sense to be cautious. Growth stocks and index tracking funds were the poster children of 2017. This year a more defensive approach is warranted, if only on the basis that lightning seldom strikes twice in the same place.
Inflation may not become broad-based but industrial metal prices and freight rates have been rising since 2016. Oil has now broken out on the upside, and monetary tightening and balance sheet reduction are the watchwords of the leading central banks – even if most have failed to act thus far.
A traditional value-based approach to stocks should be adopted. Japan may continue to play catch up with its developed-nation peers – the demographic uptick, mentioned by Dent Research, suggests that the recent breakout may be sustained. The Federal Reserve is leading the reversal of the QE experiment, so the US stock market is probably most vulnerable, but the high correlations between global stock markets mean that, if the US stock market catches a cold, the rest of the world is unlikely to avoid infection.
High-yield bonds have been the alternative to stocks for investors seeking income for several years. Direct lending and private debt funds have raised a record amount of assets in the past couple of years. If the stock market declines, credit spreads will widen and liquidity will diminish. In the US, short-dated government bond yields have been rising steadily and yield curves have been flattening. Nonetheless, high grade floating rate notes and T-bills may be the only place to hide, especially if inflation should rise even as stocks collapse.
There will be a major stock market correction at some point – there always is. When it will happen is still in doubt, but the world is nearer the end of the bull market than the beginning. Technical analysis suggests that one must remain long, but in the current low volatility environment, it makes sense to use a trailing stop-loss to manage the potential downside risk.
Many traders are adopting a similar strategy and the exit will be crowded when one reaches the door. One can expect slippage on their stop-loss, it’s a price worth paying to capture the second-longest bull market in history.
The End of the US Bull Market: Are We There Yet?
The calendar year may have changed recently, but the underlying trend in global equity markets has not. The bulls are still in charge and the major indices have all continued to track higher (talk about year highs when it is only a handful of days old is simply ridiculous, although it happens!).
In terms of Wall Street, as we and almost all value-based investors have noted, from a historical perspective it is hard to argue that US large cap equities are cheap, rather the contrary – they appear richly priced.
According to one school of thought, the continued gains in US equity prices when valuations are stretched is just a classic example of “irrational exuberance”. Indeed, as we noted in our final market insight of 2017, using market-price-based proxies of investor sentiment, it is easy to see why some have arrived at such a conclusion.
Does this mean the answer to the children’s classic travel question “Are we there yet?” – ‘there’ being an end to the second-longest Wall Street bull market on record – is now a ‘yes’?
Our crowd-sourced sentiment data suggests not. In fact, there is strong evidence supporting an alternative, diametrically opposed, market scenario.
One of the recurring themes in our market commentaries over the past several quarters has been that when one examines the collective tone of millions of online financial comments posted every day – encompassing both traditional and social media – extreme bullishness has been (and remains) largely absent. In fact, scanning across the major indices, we observe extremely high crowd-sourced sentiment in only two equity markets – India’s Nifty 50 and the Swiss SMI (see exhibit below).
Exhibit 1: Crowd-Sourced Sentiment – Major Equity Indices
Hence, a top-down look at our crowd-sourced sentiment indicators directly contradicts the irrational exuberance bubble scenario, not just in the US, which is the primary focus of this market insight, but globally.
What our indicators appear to be picking up – something that may not be fully captured in market prices – is that there has been a high degree of scepticism about the ongoing rally in US equity prices.
After all, consider the slew of articles in the financial press over the past year warning about the overvalued equities and the possibility of a stock market crash. If it subsequently transpires that we are on the precipice of a major decline in US equities (probably global given contagion risks), then this will be one of the most predicted “bubble bursts” we have ever encountered.
Markets tend not to operate that way.
Our perception of how markets operate is more masochistic. We see prices tending to move in a manner that inflicts the most pain, to the most number of people, in the shortest space of time.
A touch cynical perhaps, but based on our many years on the buy-side, it is true nonetheless.
At present, we judge the most pain to be on a move higher in US stocks, not lower. To explain why, we need to take a look at how our US equity sentiment indicators evolved over the past year.
As mentioned, crowd sentiment towards US equities is marginally above the long-run average suggesting only mild optimism. This is the case – and has been for much of the past 12 months – because of an absence of positivity in traditional financial media. Indeed, we commented on the unusual divergence between the tone of the two media types, with social (which we consider to be more reflective of a retail investor mindset) being considerably more positive than traditional media (which we consider to be more reflective of a professional investor mindset) in an earlier market insight.
While we cannot know this with absolute certainty – we convert millions of online articles posted every day from text into data for a reason (it being impossible to read everything that is published) – our strong belief is that this scepticism amongst professional investors comes from a sense that the bull market has been a “central-bank-induced-fake” whose foundations are in the process of being undermined by the removal of monetary stimulus.
Exhibit 2: Crowd-Sourced Sentiment By Media Type – S&P500
The economic logic that underpins such scepticism is sound, given that monetary policy can only generate intertemporal redistributions of aggregate demand ie. bring future demand forward, it can’t create it out of thin air. However, asset markets do not always act in accordance with economic logic and for those investors who have been underweight equities based on such logic the continued ascent in equity prices has been painful.
The financial pain is rather obvious. Underperformance is never good for an active manager but especially so at the present time given the increasing popularity of lower-cost passive investments.
Less obviously, but potentially just as powerful, is the emotional pain.
The Emotional Impacts
FOMO, or the Fear Of Missing Out, (the acronym only came to prominence in the past few years as a result of its social media usage but its long-hand version has been known for much longer) triggers a response in the amygdala area of the brain as social exclusion is perceived as a threat. Like many other traits, evolution endowed us to help us pass on our genes successfully to the next generation, it has unexpected side-effects in terms of how we perform as investors.
Given the relative lack of enthusiasm for US equities amongst professional investors compared with their retail counterparts, a perspective challenged by the ongoing rise in equity prices (so much for “smart” versus “dumb” money labels), the FOMO effect is likely to be most potent with the former.
Indeed, glancing at the right-hand side of the above exhibit, shows the two series have converged over the past several weeks, with social media becoming less positive, whereas traditional media has become more constructive in tone.
This recoupling is important.
Unlike the irrational exuberance view, which implicitly implies that the next major move in equity prices is downward, if the FOMO effect is at play the implications are markedly different. Not only would it suggest that the second-longest bull market on record has longevity, but as investors buy US stocks to avoid “missing out”, it could trigger a “melt-up” in equities – a scenario recently outlined by GMO’s Jeremy Grantham.
It is the same (overvalued) starting point – two very different market outcomes.
The recent uptick in mainstream media sentiment, is not the only evidence supporting the FOMO-driven “melt-up” scenario. The algorithms underlying our sentiment indicators are calibrated so as to be able to identify individual emotions, such as joy, anger, disgust etc, contained in online financial media posts.
Of the eight individual emotions we identify, our previous research indicates that fear is the most useful as it is strongly correlated with equity market corrections (and periods of rising volatility). Even though fear and FOMO share a common word – fear, rather obviously! – the two have very different connotations and linguistic fingerprints. Indeed, fear can be considered the exact opposite of FOMO. The former reflects worries that the stock market will decline whereas the latter stems from investors’ concerns about missing a continued price rally.
Exhibit 3: Crowd-Sourced Fear Sentiment – US equities
Hence, to be consistent with the FOMO hypothesis, one should expect crowd-sourced fear sentiments towards US equities to be on the low side, and indeed this is what we observe – as displayed in the exhibit above. In fact, over the past week or so, fear sentiment towards US equities has fallen to record lows – a trend that is by no means exclusive to the US. Scanning across the major equity indices, one can readily observe that the fear sentiment is either low or extremely low with the exception of the Brazilian BOVESPA – see exhibit below.
Exhibit 4: Crowd-Sourced Equity Fear Sentiment – Global Heatmap
The final, and in our judgement the most compelling, piece of evidence for the FOMO effect comes from the rise in our crowd-sourced stress indicator for US equities. As shown in the exhibit below, stress has risen sharply over the past several weeks.
Exhibit 5: Crowd-Sourced Stress Indicator – US & S&P500
Given the jump in the US equity stress indicator, one would expect there to be some readily identifiable catalyst. Typically, a rise in equity stress would correlate with developments such as a slump in asset prices (as occurred in early 2016), increased worries about US economic prospects and/or other non-economic events, such as geopolitical tensions that would also show up in the country level indicator – see exhibit above.
But, US economic prospects remain constructive and Stress at the country-level, although it has been elevated previously, has begun to fall. (At the country level, the US presently is the top of the leaderboard when it comes to anger and disgust – something we strongly suspect is related to feelings about President Trump more than anything else).
Ruling out these two possibilities, and obviously, in the absence of a market correction, the natural candidates for rising stress in US equities are missing. However, one would expect to see stress pick-up as equity markets continue to march higher if the FOMO effect was at play as this would be consistent with the emotional pain described previously.
Assuming this to be the case, then not only should US (and global) equity markets continue to defy “valuation gravity” but price momentum could very easily become even more positively skewed, consistent with an unfolding of the “melt-up” scenario.
This is because the intensity of the FOMO effect becomes greater the more equity markets rise, which in turn encourages more former sceptics to convert (a temporary positive feedback loop is created). In much the same way as commuters who scramble to make the last train home feel great when they finally jump on board, the conversion would boost sentiment and contribute to lowering stress levels.
However, and not without some irony, a FOMO-induced “melt-up”, marked by rising crowd sentiment and declining stress would, when combined with stretched valuations, bear the hallmarks of a classic “irrational exuberance” bubble top.
That would be the point at which to worry, but we are not there yet!
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